What’s the Potential for Outperformance in Crossover Credits?
As the cycle progresses further into its late stages, upward rating migration may continue due to improving fundamentals, operational enhancements, and active balance sheet repair. After spending a good portion of the past year repairing their balance sheets through asset sales and debt pay downs, energy companies have been the prime beneficiaries of positive rating actions in 2017. According to Barclays, of the credits that have seen upgrades into investment grade year to date, a full 60% of the volumes have occurred in the energy sector. Credits outside the commodity related sectors have only represented 30% of total volumes and those were largely driven by credit specific factors.
This past year has seen the volumes of names dropping to non-investment grade at decade lows. This followed 2016, which was the fourth largest year out of the last 20 years for credit volumes falling into the high yield index. However, expectation of further credit upgrade volumes in the coming year does not mean credit downgrades will be low. For example, consumer leveraged issuers (i.e. retailers) and select pharmaceutical names are likely to be vulnerable to ratings pressure in the coming year.
Identifying ratings migration patterns can provide a path to outperformance in the months leading up to a ratings event. Credits trending to high yield ratings generally underperform in the months prior to a ratings cut and outperform following the transfer to high yield. In contrast, credits progressing to investment grade have been shown to outperform in the months prior to a ratings upgrade. However, todays chart highlights how the capacity of further outperformance of credits migrating to investment grade is constrained. The Bloomberg Barclays Corporate Crossover Index option adjusted spread (OAS) has compressed to the BBB Corporate Index OAS to a basis not experienced since the financial crisis. The OAS differential was at its long-term tights in 2005. The tight trading levels and global reach for yield have fed the spread compression and leaves less room for credit rating upgrade driven performance.
There are names and sectors on which to be constructive given the deleveraging stories and stabilizing cash flow generation. The outlook for ratings upgrades to investment grade is expected to be at levels similar to the current year. As a result of price stability in global commodities and actions taken to rightsize balance sheets, metals and mining names will likely highlight rating upgrades along with some energy credits. However, room for outperformance in crossover names has become limited by narrow trading levels. Outperformance now more than ever may largely be as much a function of avoiding deteriorating credits as it is identifying credit upgrade stories.
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